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TIPS and the Nature of Inflation Protection

by Daniel W. Wallick and Jill Marshall

TIPS And The Nature Of Inflation Protection Splash image

The Federal Reserve Board’s aggressive and accommodative measures to bring down interest rates, thereby stimulating the economy, continue to raise concerns about future inflation, even while many feared the economy could be heading into a prolonged deflationary period. In turn, the prospect of higher inflation has sparked considerable investor interest in Treasury Inflation-Protected Securities (TIPS) and other inflation-hedging assets.

Cash flow into TIPS this year was $7 billion though September 30, 2010, as compared to $27 billion and $13 billion for full years 2009 and 2008, respectively. The significant increase in 2009 cash flow was in part due to investors’ flight to safety. Total net assets of $104.5 billion as of September 30, 2010, clearly indicate that the TIPS market has experienced significant growth since the government’s first inflation-protected bond was issued in January 1997.

An important reminder for investors seeking to protect a portfolio’s purchasing power is the fact that the total return on a TIPS fund is a function of both actual trailing inflation and the bond market’s expectation regarding future inflation. Consequently, while a TIPS portfolio does adjust an investor’s principal investment by the actual trailing inflation rate, changes in inflation expectations can produce subpar or negative total returns even when actual inflation is positive. Yet, regardless of the direction inflation takes in the future, some bond investors may benefit from knowing that they have some degree of inflation protection.

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Daniel W. Wallick is a principal with the Vanguard Investment Strategy Group.
Jill Marshall is an investment analyst with the Vanguard Investment Strategy Group.


Discussion

John from New York posted over 3 years ago:

The article does a good job explaining the mechanics of TIPs bonds, but an additonal important factor to consider is the tax consequences of ownership. If you own TIPS bonds, you must report as OID (original Issue Discount) any increase in the inflation-adjusted principal amount of the instrument that occurs while you held the instrument during the year, reported as ordinary interest. In this respect TIPS are treated just like STRIPS, differing in the fact that the inflation-adjusted principal will vary every 6 months! See IRS Publication 1212 for more details.


Peter from Maryland posted over 2 years ago:

Bond prices go up when interest rates go down. So isn't it possible for the interest risk premium to be negative? For example, if interest rates are already very high, and the main "risk" is that they may fall?


Charles from Wisconsin posted over 2 years ago:

Look at the website shadowstats.com
The US Government has a huge conflict of interest in both defining inflation for the purpose of TIPS and paying the coupon.
TIPS are analogous to equity indexed annuities heavily marketed by the life insurance industry


Jim from Connecticut posted over 2 years ago:

Once again the US government makes it difficult for the individual investor to invest for retirement. Shame on Uncle Sam!


Jim from Connecticut posted over 2 years ago:

i'll just give up contributing, drink my coffee, watch the sunrise, chill and claim "medicaid, unemployment etc"


Scott from New York posted over 2 years ago:

These bonds aren't really all I thought they were cracked up to be. I'm disappointed.


Gerry from Illinois posted about 1 year ago:

Suggest readers consider a senior bank loan fund such as BKLN as an alternative to TIPS. Not as credit worthy as TIPS, but highly collaterized and a reliable inflation-protected yield, as such loans are adjusted every 30-90 days to a LIBOR+ rate.


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